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Friends, Updating here the recollected questions from Dec 2017 Exams. Wish you all the very best for your exam.
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Understanding Altman Z-Score with example
The Altman Z-score is the output of a credit-strength test that gauges a publicly traded manufacturing company's likelihood of bankruptcy. The Altman Z-score is based on five financial ratios that can be calculated from data found on a company's annual 10K report. It uses profitability, leverage, liquidity, solvency and activity to predict whether a company has a high degree of probability of being insolvent.
The Altman Z-score is calculated as follows:
Z-Score = ([Working Capital / Total Assets] x 1.2) + ([Retained Earnings / Total Assets] x 1.4) + ([Operating Earnings / Total Assets] x 3.3) + ([Market Capitalization / Total Liabilities] x 0.6) + ([Sales / Total Assets] x 1.0)
or
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
A = working capital / total assets
B = retained earnings / total assets
C = earnings before interest and tax / total assets
D = market value of equity / total liabilities
E = sales / total assets
As you can see, the Altman score weights different profitability and liquidity metrics to arrive at the overall score. This overall score is then compared to the following grading scale.
0 – 1.8 indicates the company will declare bankruptcy in the future.
1.8 – 3 indicates the company is in a statistical“gray area" and likely to declare bankruptcy.
3+ indicates the company is will not declare bankruptcy.
It is helpful to examine why these particular ratios are included. Let's take a look at the significance of each one:
Working Capital/Total Assets (WC/TA)
This ratio is a good test for corporate distress. A firm with negative working capital is likely to experience problems meeting its short-term obligations because there simply is not enough current assets to cover those obligations. By contrast, a firm with significantly positive working capital rarely has trouble paying its bills. (For background reading, see Working Capital Works.)
Retained Earnings/Total Assets (RE/TA)
This ratio measures the amount of reinvested earnings or losses, which reflects the extent of the company's leverage. Companies with low RE/TA are financing capital expenditure through borrowings rather than through retained earnings. Companies with high RE/TA suggest a history of profitability and the ability to stand up to a bad year of losses.
Earnings Before Interest and Tax/Total Assets (EBIT/TA )
This is a version of return on assets (ROA), an effective way of assessing a firm's ability to squeeze profits from its assets before factors like interest and tax are deducted.
Market Value of Equity/Total Liabilities (ME/TL)
This is a ratio that shows - if a firm were to become insolvent - how much the company's market value would decline before liabilities exceed assets on the financial statements. This ratio adds a market value dimension to the model that isn't based on pure fundamentals. In other words, a durable market capitalization can be interpreted as the market's confidence in the company's solid financial position.
Sales/Total Assets (S/TA)
This tells investors how well management handles competition and how efficiently the firm uses assets to generate sales. Failure to grow market share translates into a low or falling S/TA.
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Example :
Company XYZ's financial statements had the following figures:
Sales : 10,00,000
EBIT : 5,00,000
Total Assets : 20,00,000
Total Liabilities : 10,00,000
Retained Earnings : 10,00,000
Market Value of Equity : 30,00,000
Working Capital : 5,00,000
Calculate XYZ's Altman score and state its insolvency probability.
XYZ's Altman score would be calculated like this:
A = working capital / total assets
B = retained earnings / total assets
C = earnings before interest and tax / total assets
D = market value of equity / total liabilities
E = sales / total assets
A = 5,00,000 / 20,00,000 = 0.25
B = 10,00,000 / 20,00,000 = 0.5
C = 5,00,000 / 20,00,000 = 0.25
D = 30,00,000 / 10,00,000 = 3
E = 10,00,000 / 20,00,000 = 0.5
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
= 1.2(0.25) + 1.4(0.5) + 3.3(0.25) + 0.6(3) + 1.0(0.5)
= (0.3 + 0.7 + 0.825 + 1.8 + 0.5)
= 4.125
XYZ's Altman score is 4.125.
This means that the company isn’t close to insolvency. It is doing well with a score well above the 3+ rating. This means that investors and creditors shouldn’t be too worried about the company according to this metric. Instead, they should look to other indicators to get a full picture of XYZ’s business.
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Another example for Altman Z-Score
Company X's financial statements had the following figures:
Sales - 4080
Earnings Before Interest & Taxes - 173
Current Assets - 1640
Total Assets - 2570
Current Liabilities - 1310
Total Liabilities - 1640
Retained Earnings - 614
Market Value of Equity - 1400
Calculate X's Altman score and state its insolvency probability.
X's Altman score would be calculated like this:
A = working capital (current assets - current liabilities) / total assets
B = retained earnings / total assets
C = earnings before interest and tax / total assets
D = market value of equity / total liabilities
E = sales / total assets
A = 330 / 2570 = 0.13
B = 614 / 2570 = 0.24
C = 173 / 2570 = 0.07
D = 1400 / 1640 = 0.85
E = 4080 / 2570 = 1.59
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
= 1.2(0.13) + 1.4(0.24) + 3.3(0.07) + 0.6(0.85) + 1.0(1.59)
= (0.156 + 0.336 + 0.231 + 1.51 + 1.59)
= 2.823
0 – 1.8 indicates the company will declare bankruptcy in the future.
1.8 – 3 indicates the company is in a statistical“gray area" and likely to declare bankruptcy.
3+ indicates the company is will not declare bankruptcy.
As company X's Altman score is 2.823, it indicates that the company is in a statistical “gray area" and likely to declare bankruptcy.
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Altman Z-Score - Try yourselves
Company X's financial statements had the following figures:
Sales - 4110
Earnings Before Interest & Taxes - 137
Current Assets - 1720
Total Assets - 2610
Current Liabilities - 1600
Total Liabilities - 1970
Retained Earnings - 438
Market Value of Equity - 1004
Calculate X's Altman score and state its insolvency probability.
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Altman Z-Score - Try yourselves
Company X's financial statements had the following figures:
Sales - 3820
Earnings Before Interest & Taxes - 6.60
Current Assets - 1510
Total Assets - 2300
Current Liabilities - 1470
Total Liabilities - 1830
Retained Earnings - 250
Market Value of Equity - 350.10
Calculate X's Altman score and state its insolvency probability.
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Altman Z-Score - Try yourselves
Company X's financial statements had the following figures:
Sales - 3280
Earnings Before Interest & Taxes - 149
Current Assets - 1070
Total Assets - 1610
Current Liabilities - 994
Total Liabilities - 1350
Retained Earnings - 63.80
Market Value of Equity - 33.10
Calculate X's Altman score and state its insolvency probability.
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Altman Z-Score - Try yourselves
Company X's financial statements had the following figures:
Sales - 2820
Earnings Before Interest & Taxes - 94.90
Current Assets - 988
Total Assets - 1430
Current Liabilities - 928
Total Liabilities - 1270
Retained Earnings - 45.6
Market Value of Equity - 73.6
Calculate X's Altman score and state its insolvency probability.
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